The Pricing Power of Brand
In the supermarket, the price of a box of Tide laundry detergent is higher than the
private-label store box — even though the box is the same size and probably works just as
well in most cases. Proctor & Gamble (the owners of the Tide brand) just has to make
sure that the price difference is not "too much."
When Nike comes out with a new Air Jordan shoe, they never have to worry about how much
Adidas is charging for their new sneaker — the only thing they have to do is figure out how
much a customer is willing to pay vs. how many they can possibly manufacture to maximize
profit.
The idea is clear. Pricing is ALWAYS important, but the stronger your brand, the more power
you have in the marketplace to set the price of your products. For the VAST majority of
businesses online, however, price is something that we have to worry about all the time.
The Effect of Technology on eCommerce Prices
During a recent panel discussion that was streaming online I heard an VC investor say,
"Technology is relentlessly deflationary." I wish could give the guy credit, but I
was listening to the event as a podcast and do not know which panelist was speaking at the
time. But the point really stuck with me and rings true. Technology makes all kinds of
businesses more efficient and drives down costs. Technology also allows consumers to be
better educated about product differentiation and to compare pricing on the fly from their
smartphones. This forces businesses to pass on the value of gained efficiencies to the
consumer.
The Big Question: "How Do I Set Prices for My Products Online?"
It used to be a lot easier. The retail rule-of-thumb was to figure out how much it cost them
to make or acquire a product wholesale and then double it. This was called
"keystoning" or "keystone pricing." Big department stores would use the
"Hotel Strategy" where they would bring in new merchandise at 3x or 4x markup
(retail price). The new stock would sell several units at full retail price, then there
would be a series of sales and discounting until the inventory was gone. The idea of the
"hotel strategy" was to sell out the items at an average price that was
profitable. Major hotel chains pioneered this pricing method, which is how it got the name.
But these practices do not work anymore (though some still try because it’s easy).
Change Your Thinking on Pricing from Margin to ROC
When you are just starting out you will experiment with products and pricing and ads. You
will make mistakes, do some things right, and fumble through a bit while you learn the
basics of selling products online. But once the business is more established and growing,
you will need to figure out how to develop a pricing model that is sustainable. Every
business is unique, but most successful online businesses today use a pricing method called
Return on Capital (ROC). Let me try to explain it by way of a simple example.
Let’s say that you want to sell T-shirts online. You started small and have learned that,
once you get the volume up to 10,000 units per year buying in lots of 1,000 units, these are
your costs:
- Finished T-shirts — $7.00 each
- Overhead (website, apps, services, storage, insurance, etc. per year) — $6,000
Remember that you can purchase in lots of 1,000, so with each completed sale you get that
money back to buy more shirts with. That means you will need a minimum of $7,000 worth of
inventory. Overhead is usually a fixed cost whether you sell 1 shirt or many. This means
that you need to keep ~$13,000 invested in the company at all times.
Now, let’s look at per-unit costs. With each successful sale, these might be your
approximate costs:
- Labor/Fulfillment Service — $2.00 each
- Packaging (envelop or box) — $1.50 each
- Shipping (if you provide free shipping) — $4.00 each
- Cost of Customer Acquisition (CCA)/Marketing (Facebook ads, etc.) — $3.00
- Transaction costs (credit card/banking fees) — $0.60
When you add these items to the single shirt unit price you discover that a single, one-time
shirt purchase costs you $18.10 to make, market, and deliver to your customer. If you reach
your target of 10,000 sales this year, then the overhead cost is distributed across each
shirt, or $0.60 each, for a total of $18.70 per shirt. Said another way, if the average
price of each shirt you sell is less than $18.70 you will lose money.
There are, of course, other things to consider such as the number of returns, shelf-loss
(damage, lost products), and there are ALWAYS unknowns that you just don’t learn until you
have been an active practitioner of your business for a while. But let’s stick with that
number to keep it simple.
If you sell 10,000 T-shirts each year at $20 each, thus making $1.30 for each one, then you
will net about $13,000. If you looked at your profit as a pure "margin," that’s
only 6.5% profit on each sale. But since the inventory turns over 10 times during the year,
that yields a 2x ROC if you manage the business well. If your costs come in higher or you
sell fewer shirts, you will have a lower ROC. If your costs come in lower or you sell more
shirts, you will have a higher ROC.
Another advantage of using ROC as a pricing strategy is that you can easily and quickly see
two things:
- How a slight increase or decrease in the cost of a single input (marketing, shipping,
packaging, etc.) can have immediate and dramatic impacts on the business return.
- How a customer ordering multiple items and/or repurchasing has more net value to your
business than a new, single-item purchaser.
Maybe you are fortunate and already have a completely unique product with no direct
competitors. Sometimes this is called a "Blue Water Opportunity." But even if you
do not have competitors now, it is the nature of the internet and basic economics that you
will soon — successful products encourage new competitors to enter the field. That’s why
it’s important to constantly evaluate and refine your pricing strategy within the
competitive landscape.
Using Competitive Analysis to Refine Your Pricing Model
The T-shirt company numbers in the previous example are real. If you wanted to start an
online T-shirt selling business, you could actually start building your pricing model with
these estimates and then adjust as real data presented itself. It’s also why you see so many
T-shirts selling online for about $20.
Sure, there are a lot of variables to consider — things like whether competing products are
of the same quality, if they offer free shipping, whether or not they have a friendly
returns and exchanges policy. But if the quality and service are similar, everyone in the
T-shirt business is faced with these same constraints. If a serious competitor is selling
for less than your target price, then one or more of the following is true:
- They are willing to accept a smaller ROC and are competing on price.
- They have lower costs in one or more inputs.
- They have a high incidence of customers repurchasing and/or purchasing more than one
item at a time.
If serious competitors are selling for more than your target price, then there are three
possibilities:
- You are willing to accept a lower ROC than your competitors.
- You have a competitive cost advantage in one or more of the inputs.
- There is an unknown risk or cost missing from your calculation.
This is how pricing pushes back on marketing and production in a consistent cycle of
information feedback. It can even help you decide if a product is not a good fit for you to
sell.
Summary
Using the ROC method of setting your initial prices is not just about setting your prices.
It is a way to understand and manage your business from a strategic vantage point and helps
you worry less about the day-to-day ups-and-downs of entrepreneurship. And it is even one of
the most important ways that venture capitalists and larger organizations evaluate
investment and acquisition opportunities.
We used a simple example of an online T-shirt business to demonstrate the idea. But with a
few minor alterations the model can be effectively applied to establish pricing for any
business selling products online. It shows why, in a highly competitive market, comparable
goods tend to drive towards a similar price over time. In part 2 of this series, we will
look at some ways to work within your pricing constraints to make your eCommerce sales more
profitable.
Take me to — Pricing Part 2: Making More eCommerce Profit.
Links and Resources
Here is a review of Return On Capital (ROC) by Investorpedia: https://www.investopedia.com/terms/r/returnoninvestmentcapital.asp
Investing site SeekingAlpha has an article that discusses the impact of advancing technology
on prices: https://seekingalpha.com/article/4417536-technology-is-eating-inflation
An explanation of keystone pricing from MarketBusinessNews: https://marketbusinessnews.com/financial-glossary/keystone-markup/